Australia leads way with 1pc rate cut as worries grow that it could be the next Iceland

Australia has stunned markets by slashing interest rates a full percentage point to stem the collapse in confidence, raising hopes that fellow central banks may soon follow suit with a worldwide monetary blitz.

The All Ordinaries Index at the Australian Stock Exchange in Sydney rose 1.7pc after the central bank cut interest rates.Photo: EPA

By Ambrose Evans-Pritchard

3:56PM BST 07 Oct 2008

Glenn Stevens, the Reserve Bank governor, was forced to move after a near seizure in interbank lending markets. "A material change to the balance of risks has occurred, requiring a significantly less restrictive stance on monetary policy," he said.

Sydney's ASX stock index surged 1.7pc after the cut, but analysts warned that the country is still extremely vulnerable to the global crunch given its heavy dependence on external US dollar funding.

"It is not clear whether Australia could offer the sort of bank guarantees that are occurring in Europe, should that prove necessary," said Hans Redeker, currency chief at BNP Paribas.

Australia has allowed its net foreign liabilities to reach 60pc of GDP during a decade-long boom, twice the level of the US. The country will in effect have to pay 4pc of GDP in the form of rents to foreign assets holders as the bill for such extravagance falls due.

"Yes, Australia has a fiscal surplus, but that does not offer as much protection as people think. If the government boosts spending further, the current account deficit will spiral out of control. There is a risk – however remote – that it could face some of the foreign funding difficulties we have seen in Iceland," he said.

The current account deficit has been running at 6.2pc of GDP this year despite bumper prices for Australia's coal, iron ore, and farm exports. The commodity crash over the last two months has now yanked the rug from under an economy that was already buckling.

Governor Stevens said household debt has risen from around 50pc of disposable income to 160pc since the early 1990s, one of the highest levels in the world.

The immediate problem for Australia's banks is that they gorged on offshore US dollar markets to fund expansion because the interest costs were lower. They were playing a version of the dollar "carry trade" on a huge scale with leverage.

The window has now jammed shut on these markets, leaving lenders struggling to roll over loans. European banks face much the same problem as dollar liabilities come back to haunt, but Australian lenders have pushed their luck even further.

The good news yesterday was that the Australian dollar rallied strongly after the rate cut. It shows tentative signs of stabilising after losing almost 30pc of its value against the US dollar since mid-July.

Sinon Derrick, currency chief at Bank of New York Mellon, said the 'Aussie' rebound suggests that there has been a crucial shift in the psychology of the exchange markets as recession looms. "Far from punishing a currency for its lack of yield – the predominant theme for several years – it seems that investors are now prepared to reward a currency where the central bank takes robust action to support the economy," he said.

The response to Australia's move is being watched very closely by other central banks. The Bank of England has felt constrained from cutting rates over recent months – despite the UK housing crash – because of fears that it would set off a fresh slide in sterling and stoke inflation. A case can now be made that a British rate cut would actually boost the pound.